Everything everywhere all at once

Henry Adams

Chief Product Officer
Wednesday, Jun, 14, 2023
3mins

Feels like we have been averting one crisis right before heading towards the next. Liquidity conditions are set to become further constrained. The extraordinary period of low rates and  massive stimulus plans are now unwinding rapidly all at the same time, almost everywhere. We have also started to observe what was fairly easy to predict: term funding premiums returning in order to attract capital.

Defaults have risen, with one US-centric estimate from Goldman Sachs indicating 27 firms going bust in the month of May. To put this into perspective, by the same metrics, the May 2022 total came in at 22 firms. It is not just the ability to service debt at higher levels that is concerning, but the outright supply of credit in a market that is attempting to digest multiple competing forces at the same time. More on that per core currency later…

It’s all good though. Certain indices are up more than 30% from their recent lows. Apple traded at an all-time high during Monday’s session, although, from what I can see, unrelated to their latest product launch. I’m not sure even using the mixed or virtual reality headset leaves these looking great. I do not claim to be at the cutting edge of fashion, typically preferring the realms of real, financial markets, but really though…these are just bad.

In Europe, longer term and cheap financing delivered to the European banking system is set to be repaid by the end of the month, with several banks in the precarious position of being unable to repay. It does not bode well for trust nor political and fiscal alignment with several Italian and Greek banks working hard to hopefully resolve the shortfall.

Last week was the busiest for European Sovereigns, reaching levels not seen since the pandemic. With reduced liquidity and demand from banks and corporates on top of the EUR 27bn going through screens since the beginning of June in government borrowing alone, competition is heating up, along with yields. For now, according to the market expectations, we are set for one additional hike in autumn. Whether this will all be enough to curtail demand, not cause a crash, and bring prices back in line is yet to be seen. The job of the central banker does not get any easier these days! The closely watched metric of Italian to German government borrowing costs, at the 10 year tenor, either does not reflect what has been going on or has fully priced in the risk and deemed it not to be significant. Personal view would be that this is incorrect.

Rates are higher, we all know that much. Refinancing risk in the UK though is now becoming painful for all. Not just in capital markets and between sophisticated and/or higher risk entities, but for you and I. Look no further than the disappearing act that is the residential mortgage market. Santander and HSBC pulled their consumer products within 24 (business) hours of one another and were both out of the market at the end of business on Monday. This represents approximately 20% of the market (thanks to UK Finance for data). Where two lead, others will follow? The aggressive repricing of the curve following continued double-digit inflation along with a tightening labour market that is also seeing revisions in pay of close to 7% is not helping the plight of the Bank of England. Government debt surpassed levels not seen since 2007/8. GDP flipped from small negative to small positive, with the Bank of England’s revised forecasts looking more optimistic. Wage inflation and the elasticity of the labour market is not likely to abate thus stagflation is seemingly hard to avoid here. At one point the peak base rate was being priced by traders at close to 6%. Not so good if you are not a saver, at least in nominal terms. Real rates though? They remain negative!

In the US, debt ceiling woes are, for now, behind us but not without considerable disruption to markets close to home for us all. Can’t see the issue going away or not, being a (big) issue again in 2025 when it will next be up for review. US treasury bills, depending on maturity, were observed at below 3% in dates prior to any expected “technical” default with those just beyond jumping as high (yield!) as 7%. Whilst political resolution was found, we will likely get the chance to do it all over again in ’25. Although this has now been resolved, the question remains as to who is going to buy what is widely estimated to be in excess of $1 trillion of Treasury Bills. No change as expected from the Fed Wednesday with further small increments in tightening on the slate, but as is now the custom, led by data.

This is happening at a time when quantitative tightening (draining liquidity previously pumped into the system to artificially reduce the price of money) is well underway and banks are continuing to experience deposit flight into parts of the market not designed to handle said cash and draining the financial system of its lifeblood. What could possibly go wrong? Well…quite a lot actually. Please do yourselves and the world a favour and drop the rate paid on overnight repo via your facility friends at the Federal Reserve…or else. Guaranteeing deposits is one thing, but subsidising the wrong part of the market is an entirely counterintuitive, nor logical thing, and, at this stage, frankly, dangerous. There was a small undershoot in inflation and manufacturing input prices over the last couple of sessions…but… Good news according to our friends at Goldman Sachs though who believe the US will now most likely avoid recession over the coming 12 months. A belief backed up by the repricing of interest rate expectations where just a few weeks ago the curve was heavily inverted, implying there was a need for emergency cuts to resuscitate an imploding economy.

There are other potential headwinds and tail risks worth remembering here. War continues, with plenty of talk of both sides escalating and further resourcing efforts. Poland requesting surface to air missiles from the UK to take down Russian fighters crossing its airspace is unlikely to end well if used in anger. And how about a slowdown in China? Well, for now, further easing has been the theme, and we are yet to see or feel the full impact.

What does all this mean for holders of cash? The asset class has performed well would be one way to think about it. Adjusted for inflation less so in certain jurisdictions. But no matter who you are, the same rules should apply. Be prudent, stay liquid, and where possible enhance risk-adjusted as well as outright yields. Play the long game.

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